How to work out your risk profile

Your risk profile is a measure of how much risk you can take on and how willing you are to accept those risks.

A common misconception is that a risk profile is determined solely by age. Some schools of thought assume that the younger you are, the more comfortable you are taking higher risks. Perhaps because you have more time to recoup any significant financial losses.

Others claim that the older you are, the more experience and therefore confidence you’d have when taking on risk.

While age certainly can be a contributing factor, there are several other things that affect your risk profile. These include where you choose to invest your capital and how much of it you’re willing to risk.

How you handle money earmarked for retirement might be different from how you treat money set aside for trading activity. In this lesson, we’ll explore three risk profiles and why it’s important to know which you belong to.

The importance of risk profiles

Knowing your risk profile could help you determine how you access the markets; from the products you trade to the stocks you invest in and everything in between.

Consider your financial goal. Do you want to save up to renovate your family home? Are you looking to make a little extra spending money before a big vacation?

With that in mind, let’s look at three ways you can make money from the market and which risk profile they may suit best.

Interest

Interest is commonly associated with savings accounts but can also be earned on mutual funds, bonds and you could even earn interest on cash not yet earmarked for an investment in some brokerage accounts. You can contact local banks or look online to discover what options are available to you.

Earning money through interest is considered stable and more predictable, whether your rate is fixed, compounded or linked to inflation. The appeal is that you’ll know upfront what interest you can expect to earn on your savings or investment, and there’s less likelihood of losing your entire capital.

Earning interest on an investment carries very little risk. However, should inflation rise above your interest rate, the value of your investment will steadily lose buying power over time.

Dividends

Dividends are a portion of a company’s profits that gets returned to shareholders. In an ideal world, you’d be able to invest in companies that issue dividends that increase above inflation every year.

However, dividends are issued at the company’s discretion and are often tied to the company’s quarterly performance. That means they can be reduced or not paid out at all.

Dividends are also linked to an institution’s share price. This is because when a company announces a surprise dividend, the share price can sometimes rise because there’s more demand for the shares.

However, it could also fall as demand can sometimes decrease following a payout. This means your initial capital can decrease in value – even when you receive dividends.

Your return is potentially better than when you’re earning interest, but the investment is riskier. There’s no guarantee that a company you’ve invested in will pay dividends. You may also experience a capital loss depending on the company’s performance. This means investing for dividend income is considered medium risk.

Price movement

When you buy an asset like a share, you’re hoping that you can sell it later at a higher price than you paid. This is investing for price movement. To take advantage of this, you’d need to purchase the asset itself, or use a leveraged product to take a position on the underlying market.

When you buy an asset that’s increasing in value, you make a profit. However, there are no guarantees that the assets you choose will appreciate. When an asset you’re invested in decreases is value, you lose money. With the benefit of time, you could withstand that loss.

If you open a leveraged position in the market, you could buy or short sell different financial instruments such as CFDs. Investing with the aim of taking advantage of price movements is considered a high-risk strategy.

Taking leveraged positions in the market takes it to the next level and is one of the biggest risks you can take with your money. Whichever you choose is likely closely tied to how much time you have and which product you choose.

It’s possible to use a blend of interest, dividends and price movement. An exchange-traded fund (ETF) with bonds or cash as its base could work very well. You might want to choose one with some shares that give you access to both dividends and price movements.

If you’re an investor who prefers to focus more on price movement, your time horizon could stretch into decades. Here you can invest in shares to generate a profit over time. You can also receive dividends along the way.

By contrast, traders interested in price movements can have investment horizons as short as a few seconds. As you can see, risk isn’t always just about how much time you have

A risk profile for every need

You may have noticed that any one person could have many different risk profiles at once, based on their goals.

A retiree may have some money they don’t need for another decade or two. They could also venture into high-risk territory with a leveraged trading strategy or an individual share portfolio, all while keeping a portion of their capital in a high-interest savings account.

Combining risk profiles will be dictated by what you need your different investments to do.

Low-, medium- and high-risk profiles

Your individual risk profile is an important part of how you interact with the markets. It’s also unique to you, which means you should determine which one matches your circumstances.

While you may fall into more than one profile at any given time, your profiles themselves may include a combination of higher and lower risk financial instruments.

Generally, these profiles fall into three main categories: low risk, medium risk and high risk.

Let’s dive into the different profiles and how you might participate in the market within each.

Low risk

A low-risk profile is generally going to consist of savings products and bonds.

By investing in a bond, you’re loaning money to the issuing institution, essentially purchasing their debt. Should you choose to make this part of your wealth-building strategy, remember that they don’t always pay out in full.

There’s a chance that only a percentage of your initial investment will be returned. However, you’ll often earn a higher interest rate than if you just put the money in a savings account.

Savings products pay predictable and regular interest that can either be reinvested or spent, depending on the need. While they may be low risk, your money could devalue.

For example, say you have a savings account with a fixed interest rate of 3% per annum and inflation is at 5% in any given year. The cash in that account will buy you 2% less at the end of the year, even with the interest earned.

Using low-risk strategies like these also tends to make a profit slower than if you purchased individual shares or traded using leveraged products.

Let’s check your understanding.

Medium risk

Here, we’re moving up the risk curve. A portfolio for a medium-risk profile could include individual shares or even collective investments like ETFs, investment portfolios and interest-bearing products.

Some people use a mix of both low-risk products and higher risk shares, essentially creating a medium-risk profile.

You might start with 80% in a savings account and only 20% in shares, changing that ratio as you become comfortable with taking on more risk.

High risk

In a high-risk profile, you might want to trade products with higher liquidity, as well as build an investment portfolio. You could add derivative products such as CFDs and other leveraged products.

The money you set aside for a high-risk portfolio should always be money you can afford to lose. This is because the markets can be volatile and there’s always the risk that you’ll lose some or all of your capital.

There are also different charges involved in these leveraged products, which could eat into any profits you might make.

Here’s a handy way you can manage how much money you’ll need to use different high-risk financial instruments:

Remember, some leveraged products like spread bets and CFDs could see you losing more than your initial outlay, so you’ll need to prepare for that financial drawdown as well.

By maintaining a solid understanding of which profile (or profiles) your wealth-building activities fall into, you’ll be able to better understand your risk appetite and therefore which products are right for you.